1. LESSON 5 The Nature of Industry McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Market structure – Firm size – Industry concentration – Technology – Demand and market conditions – Potential for entry Conduct – Pricing behavior – Integration and merger activity – Research and development – Advertising Performance – Profit – Social welfare The structure-conduct-performance paradigm – Causal view – Feedback critique – Relation to the Five Forces Framework 7-2 Chapter Overview

3. Introduction Chapter 6 focused on the optimal way to acquire the efficient mix of inputs, and how to solve various principal-agent problems that arise within the firm. This chapter provides an overview of the nature of various industries. – How concentrated are sales in one industry relative to another? – How do price-cost margins vary by industry? – How do advertising and R&D expenditures vary by industry? 7-3 Chapter Overview

4. Market Structure Market structure factors that impact managerial decisions: – Number of firms competing in an industry. – Relative size of firms (concentration). – Technological and cost conditions. – Demand conditions. – Ease of firm exit or entry. 7-4 Market Structure

5. Industry Concentration Measures the size distribution of firms within an industry. – Are there many small firms? – Are there only a few large firms? 7-5 Market Structure

6. Measuring Industry Concentration 7-6 Market Structure

7. Measuring Industry Concentration in Action 7-7 Market Structure

8. Measuring Industry Concentration In Action 7-8 IndustryC 4 (percentage) HHI Distilleries701,519 Fluid milk461,075 Motor vehicles681,744 Snack foods531,984 Furniture and related products1162 Semiconductor and other electronic components 34476 Soft drinks52891 Market Structure

9. Limitations of Concentration Measures Factors that impact and limit industry concentration measures include: – Global markets. – National, regional and local markets. – Industry definitions and product classes. 7-9 Market Structure

10. Technology and Costs Industries differ in regard to the technologies used to produce goods and services. – Labor-intensive industries. – Capital-intensive industries. Within a given industry if the available technology is: – the same, firms will likely have similar cost structures. – different, one firm will likely have a cost advantage. 7-10 Market Structure

11. Demand and Market Conditions 7-11 Market Structure

12. Demand and Market Conditions in Action 7-12 Market Structure

13. Demand and Market Conditions In Action 7-13 IndustryOwn Price Elasticity of Market Demand Own Price Elasticity of Demand for Representative Firm Rothschild Index Food-3.80.26 Tobacco-1.3 1.00 Textiles-1.5-4.70.32 Apparel-1.1-4.10.27 Paper-1.5-1.70.88 Chemicals-1.5 1.00 Petroleum-1.5-1.70.88 Market Structure

14. Potential for Entry Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market. Several factors can create barriers to entry (or make entry difficult). – Capital requirements. – Patents. – Economies of scale. 7-14 Market Structure

15. Conduct Behavior of firms: – Price markup over costs. – Integration and merger. – Advertising expenditures. – Research and development expenditures. 7-15 Conduct

16. Pricing Behavior 7-16 Conduct

17. Pricing Behavior in Action 7-17 Conduct

18. Pricing Behavior In Action 7-18 IndustryLerner IndexMarkup Factor Food0.261.35 Tobacco0.764.17 Textiles0.211.27 Apparel0.241.32 Paper0.582.38 Chemicals0.673.03 Petroleum0.592.44 Conduct

19. Integration and Merger Activity Integration – Uniting productive resources of firms. – Can occur during the formation of a firm. Merger – Two or more existing firms “unite,” or merge, into a single firm. Reasons firms merge: – Reduce transaction costs. – Reap benefits of economies of scale and scope. – Increase market power. – Gain better access to capital markets. 7-19 Conduct

20. Types of Integration Vertical integration – Various stages in the production of a single product are carried out in a single firm. Horizontal integration – Merging two or more similar final products into a single firm. Conglomerate mergers – Integration of two or more different product lines into a single firm. 7-20 Conduct

21. Research and Development Research and development – Expenditures made by firms to gain a technological advantage, with the aim of acquiring a patent. 7-21 CompanyIndustryR&D as Percentage of Sales Bristol-Meyers SquibbPharmaceuticals19.7 FordMotor vehicle and parts4.1 Goodyear Tire and RubberRubber and plastic parts2.0 KelloggFood1.5 Proctor & GableSoaps and cosmetics2.5 Conduct

22. Advertisement – Expenditures made by firms to inform or persuade consumers to purchase their products. 7-22 CompanyIndustryAdvertising as Percentage of Sales Bristol-Meyers SquibbPharmaceuticals4.9 FordMotor vehicle and parts3.2 Goodyear Tire and RubberRubber and plastic parts2.5 KelloggFood9.2 Proctor & GableSoaps and cosmetics11.7 Conduct

23. Dansby-Willig Performance Index Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount. 7-23 IndustryDansby-Willig Index Food0.51 Rubber0.49 Textiles0.38 Apparel0.47 Paper0.63 Chemicals0.67 Petroleum0.63 Performance

24. Structure-Conduct-Performance Structure: – Factors like technology, concentration and market conditions. Conduct: – Individual firm behavior in the market. Behavior includes pricing decisions, advertising decisions and R&D decisions, among other factors. Performance: – Resulting profit and social welfare that arise in the market. Structure-conduct-performance paradigm – Model that views these three aspects of industry as being integrally related. 7-24 The Structure- Conduct-Performance Paradigm

25. The Casual View Market structure “causes” firms to behave in a certain way. … this behavior, or conduct, “causes” resources to be allocated in certain ways. … this resource allocation leads to “good” or “bad” performance. 7-25 The Structure- Conduct-Performance Paradigm

26. The Feedback Critique There is no one-way causal link among structure, conduct and performance. – Firm conduct can affect market structure; – Market performance can affect conduct and market structure. 7-26 The Structure- Conduct-Performance Paradigm

27. Five Forces Framework 7-27 Power of Input Suppliers  Supplier Concentration  Price/Productivity of Alternative Inputs  Relationship-Specific Investments  Supplier Switching Costs  Government Restraints Power of Buyers  Buyer Concentration  Price/Value of Substitute Products or Services  Relationship-Specific Investments  Customer Switching Costs  Government Restraints Entry Substitutes & Complements Industry Rivalry  Concentration  Price, Quantity, Quality, or Service Competition  Degree of Differentiation Level, Growth, and Sustainability Of Industry Profits  Entry Costs  Speed of Adjustment  Sunk Costs  Economies of Scale  Network Effects  Reputation  Switching Costs  Government Restraints  Price/Value of Surrogate Products or Services  Price/Value of Complementary Products or Services  Network Effects  Government Restraints  Switching Costs  Timing of Decisions  Information  Government Restraints The Structure- Conduct-Performance Paradigm

28. Looking Ahead Perfect competition – Many, small firms and consumers relative to market. – Firms produce very similar products. – No market power (P = MC). Monopoly – Sole producer of good or service. – Market power (P > MC). Monopolistic competition – Many, small firms and consumers relative to market. – Firms produce slightly different products. – Limited market power. Oligopoly – Few, large firms tend to dominate market. – Price/marketing strategies are mutually interdependent with other firms in the industry. 7-28 Overview of the Remainder of the Book

29. Conclusion Modern approach to studying industries involves examining the interrelationship between structure, conduct and performance. Industries dramatically vary with respect to concentration levels. – The four-firm concentration ratio and Herfindahl- Hirschman index measure industry concentration. The Lerner index measures the degree to which firms can markup price above marginal cost; it is a measure of a firm’s market power. Industry performance is measured by industry profitability and social welfare. 7-29

30. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

31. Four Basic Market Types 1.Perfect Competition (no market power) – Large number of relatively small buyers and sellers – Standardized product – Very easy market entry and exit – Nonprice competition not possible

32. 2.Monopoly (absolute market power subject to government regulation) – One firm, firm is the industry – Unique product or no close substitutes – Market entry and exit difficult or legally impossible – Nonprice competition not necessary

33. 3.Monopolistic Competition (market power based on product differentiation) – Large number of relatively small firms acting independently – Differentiated product – Market entry and exit relatively easy – Nonprice competition very important

34. 4.Oligopoly (market power based on product differentiation and/or the firm’s dominance of the market) – Small number of relatively large firms that are mutually interdependent – Differentiated or standardized product – Market entry and exit difficult – Nonprice competition very important among firms selling differentiated products

36. Pricing and Output Decisions in Perfect Competition

37. Unrealistic? Why Learn? Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms. It is a useful benchmark. Explains why governments oppose monopolies. Illuminates the “danger” to managers of competitive environments. – Importance of product differentiation. – Sustainable advantage.

38. Key assumptions of the perfectly competitive market – The firm operates in a perfectly competitive market and therefore is a price taker. – The firm makes the distinction between the short run and the long run. – The firm’s objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss. – The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

39. Setting Price Firm QfQf $ DfDf Market QMQM $ D S PePe

40. Profit-Maximizing Output Decision MR = MC. Since, MR = P, Set P = MC to maximize profits.

41. Graphically: Representative Firm’s Output Decision $ QfQf ATC AVC MC P e = D f = MR Q f* ATC PePe Profit = (P e - ATC)  Q f*

42. A Numerical Example Given – P=$10 – C(Q) = 5 + Q 2 Optimal Price? – P=$10 Optimal Output? – MR = P = $10 and MC = 2Q – 10 = 2Q – Q = 5 units Maximum Profits? – PQ - C(Q) = (10)(5) - (5 + 25) = $20

43. The firm incurs a loss. At the optimum output level price is below average cost. However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss.

44. Shutdown Decision Rule A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. – Operating results in a smaller loss than ceasing operations. Decision rule: – A firm should shutdown when P < min AVC. – Continue operating as long as P ≥ min AVC.

45. Shutdown Point: the lowest price at which the firm would still produce. At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution margin. If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs.

46. $ QfQf ATC AVC MC Q f* P min AVC Firm’s Short-Run Supply Curve: MC Above Min AVC

47. Long Run Adjustments? If firms are price takers but there are barriers to entry, profits will persist. If the industry is perfectly competitive, firms are not only price takers but there is free entry. – Other “greedy capitalists” enter the market.

48. Effect of Entry on Price? Firm QfQf $ DfDf Market QMQM $ D S PePe S* P e* D f* Entry

49. Summary of Logic Short run profits leads to entry. Entry increases market supply, drives down the market price, increases the market quantity. Demand for individual firm’s product shifts down. Firm reduces output to maximize profit. Long run profits are zero.

50. Features of Long Run Competitive Equilibrium P = MC – Socially efficient output. P = minimum AC – Efficient plant size. – Zero profits Firms are earning just enough to offset their opportunity cost.

51. Effect of an increase in DD in a PC market Initial position P=AC (no economic profits= accounting profits cover opportunity cost) Demand increases Mkt price increases in the SR Firms have an incentive to produce more output with available capacity Firms make economic profits Profits attract entrants New entrants increase SS and reduce market price Price decreases unit P=AC Final Price is higher or lower depending on higher or lower input prices as output increases

52. As identical firms expand output and demand more inputs, price of inputs increase, increasing costs. Final price exceeds initial price As firms expand output and demand more inputs, price of inputs decrease, decreasing costs. Final price is lower than the initial price

53. Effects of an increase in variable cost in a PC market Initial situation P=AC Variable cost increases Firms have an incentive to produce less output with available capacity Firms have economic losses Firms exit market Market price increases (until P=AC) Final LR market price is higher to compensate for higher variable cost

54. Effect of an increase in Fixed costs in a PC market Initial situation P=AC Fixed costs increase Market price does not change in the SR because MC is not affected Firms have economic losses Firms exit SS decreases, market price increases Market price increases until P=AC LR market price is higher to compensate for the higher fixed cost

55. Case: Trucking Industry Higher gas prices  increasing costs  increase in price of transporting cargo Some truckers add airfoils to their truck to compensate for higher gas prices In the SR, the first truckers with airfoils earn profits Profits induce other truckers to add airfoils or equivalent devices to their trucks In the LR, airfoils or equivalents are necessary for survival but not sufficient for profits

56. Monopoly Environment Single firm serves the “relevant market.” Most monopolies are “local” monopolies. The demand for the firm’s product is the market demand curve. Firm has control over price. – But the price charged affects the quantity demanded of the monopolist’s product.

57. Managing a Monopoly Market power permits you to price above MC Is the sky the limit? No. How much you sell depends on the price you set!

58. “Natural” Sources of Monopoly Power Economies of scale Economies of scope Cost complementarities

59. “Created” Sources of Monopoly Power Patents and other legal barriers (like licenses) Tying contracts Exclusive contracts Collusion Contract... I. II. III.

60. Monopoly Profit Maximization $ Q ATC MC D MR QMQM PMPM Profit ATC Produce where MR = MC. Charge the price on the demand curve that corresponds to that quantity.

61. A Numerical Example Given estimates of P = 10 - Q C(Q) = 6 + 2Q Optimal output? MR = 10 - 2Q MC = 2 10 - 2Q = 2 Q = 4 units Optimal price? P = 10 - (4) = $6 Maximum profits? PQ - C(Q) = (6)(4) - (6 + 8) = $10

62. Strategies to maintain a Monopoly market position Apply “limit” pricing Threaten with “predatory pricing” Invest in excess capacity Raise cost of rivals by advertising Control key inputs As on substitutes and complements Integrate vertically and horizontally Influence politicians and regulators

63. Why Government Dislikes Monopoly? P > MC – Too little output, at too high a price. Deadweight loss of monopoly.

64. $ Q ATC MC D MR QMQM PMPM MC Deadweight Loss of Monopoly

65. Arguments for Monopoly The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power. Encourages innovation.

66. Monopolistic Competition: Environment and Implications Numerous buyers and sellers Differentiated products – Implication: Since products are differentiated, each firm faces a downward sloping demand curve. Consumers view differentiated products as close substitutes: there exists some willingness to substitute. Free entry and exit – Implication: Firms will earn zero profits in the long run.

67. Managing a Monopolistically Competitive Firm Like a monopoly, monopolistically competitive firms – have market power that permits pricing above marginal cost. – level of sales depends on the price it sets. But … – The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. – Free entry and exit impacts profitability. Therefore, monopolistically competitive firms have limited market power.

68. Competing in Imperfectly Competitive Markets Non-price variables: any factor that managers can control, influence, or explicitly consider in making decisions affecting the demand for their goods and services. – Advertising – Promotion – Location and distribution channels – Market segmentation – Loyalty programs – Product extensions and new product development – Special customer services – Product “lock-in” or “tie-in” – Pre-emptive new product announcements

69. Monopolistic Competition: Profit Maximization Maximize profits like a monopolist – Produce output where MR = MC. – Charge the price on the demand curve that corresponds to that quantity.

70. Short-Run Monopolistic Competition $ ATC MC D MR QMQM PMPM Profit ATC Quantity of Brand X

71. Long Run Adjustments? If the industry is truly monopolistically competitive, there is free entry. – In this case other “greedy capitalists” enter, and their new brands steal market share. – This reduces the demand for your product until profits are ultimately zero.

72. $ AC MC D MR Q* P* Quantity of Brand X MR 1 D1D1 Entry P1P1 Q1Q1 Long Run Equilibrium (P = AC, so zero profits) Long-Run Monopolistic Competition

73. Monopolistic Competition The Good (To Consumers) – Product Variety The Bad (To Society) – P > MC – Excess capacity Unexploited economies of scale The Ugly (To Managers) – P = ATC > minimum of average costs. Zero Profits (in the long run)!

74. Maximizing Profits: A Synthesizing Example C(Q) = 125 + 4Q 2 Determine the profit-maximizing output and price, and discuss its implications, if – You are a price taker and other firms charge $40 per unit; – You are a monopolist and the inverse demand for your product is P = 100 - Q; – You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

75. Marginal Cost C(Q) = 125 + 4Q 2, So MC = 8Q. This is independent of market structure.

76. Price Taker MR = P = $40. Set MR = MC. 40 = 8Q. Q = 5 units. Cost of producing 5 units. C(Q) = 125 + 4Q 2 = 125 + 100 = $225. Revenues: PQ = (40)(5) = $200. Maximum profits of -$25. Implications: Expect exit in the long-run.

77. Monopoly/Monopolistic Competition MR = 100 - 2Q (since P = 100 - Q). Set MR = MC, or 100 - 2Q = 8Q. – Optimal output: Q = 10. – Optimal price: P = 100 - (10) = $90. – Maximal profits: PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375. Implications – Monopolist will not face entry (unless patent or other entry barriers are eliminated). – Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.

78. Conclusion Firms operating in a perfectly competitive market take the market price as given. – Produce output where P = MC. – Firms may earn profits or losses in the short run. – … but, in the long run, entry or exit forces profits to zero. A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

79. Oligopoly Oligopoly is a market dominated by a relatively small number of large firms » Unconcentrated markets have HH < 1,000 Products are either standardized or differentiated Barrier to entry exist Price, Output and profits depend on actions, reactions, and counteractions

80. Basic Oligopoly Models “Sweezy” Oligopoly – A firm assumes that rivals will cut prices when it reduces its price but will not increase prices when it increases the price – result: Price rigidity “Cournot” Oligopoly – A firm decides its output based on the output of rivals and vice versa – results: firms divide the market “Betrand” Oligopoly – Firms compete by undercutting each other’s price – result: Price wars and no profits “Stakelberg” Oligopoly: A firm moves first and commits to an output level before rivals. Rivals decide their output based on the leader’s output – results: staus quo

81. Cartel Agreement among competing firms to fix prices, output and marketing. Occurs in oligopoly markets Can be explicit or Implicit Legal or illegal

82. Explicit Cartels Pure – all firms join the cartel and all have the same costs and costs structure Perfect – all firms join the cartel but firms have different costs and cost structures Imperfect – Not all firms join and firms have the same or different costs and cost structures

83. Implicit Cartels Firms coordinate strategies without explicit cooperation while recognizing their interdependence. Firms play strategic games Firms exploit gray area in anti-trust laws

84. Dynamics of an Explicit Cartel (Explicit collusion) Initial position: producers behave competitively P=AC (no economic profits) Producers have an agreement to increase the price Producers set quota to control cheating Firms make economic profits As P>MC>AC, each producer has an incentive to produce more than the quota The cartel breaks down as each producer cheats The cartel has to adopt additional strategies to extend the life of the cartel

85. Some Strategies to facilitate strategic coordination Hire a cartel enforcer Centralize or consolidate trade of members and non- members Control key inputs Establish specifications and standards Hire quota enforcers Divide the market geographically Limit market shares and set collusion terms other than price Influence government so that it ‘regulates” industry Pay for not producing or buy production from others

86. Case: Government as an Enforcer of coordination Government imposes tax on producers Variable cost rise, supply falls, PRP (price received by producers) fall and PPC (price paid by consumers) increase This is equivalent to a government that figurative buys x for PRP and resells x for PPC

87. Mafioso Economics Merchants in a city compete and charge price = Po "Mafioso Jane" tells merchants that they have to charge P1 (higher than Po) and threatens merchants if they do not obey Merchants in general make more profits at higher price P1. They pay for a fee or “private tax” to "Mafioso Jane" for services rendered "Mafioso Jane" acts as a cartel enforcer. Merchants gain by having "Mafioso Jane" put order in the market and discipline cheaters "Mafioso Jane" is acting like a government by regulating entry and imposing taxes